Comment: Funds of hedge funds defy predictions of extinction

Comment: Funds of hedge funds defy predictions of extinction

Funds of hedge funds were widely predicted to become one of the principal casualties of last year's annus horribilis for the hedge fund industry. While most hedge fund indices reported average declines in 2008 of up to 20 per cent, fund of funds benchmarks did even worse.

That double layer of fees, it turned out, did not buy sufficient diversification to shield investors from hedge fund managers' miserable performance; investors found themselves deprived of liquidity because fund of fund managers' were unable to redeem underlying investments; funds of funds that had leveraged up to boost returns found it was losses that had been turbo-charged; and to cap it all some managers had placed significant slugs of their investors' money with Bernard Madoff.

The demise of funds of hedge funds has been forecast for years, prompted by the lower fees and supposedly superior performance of multistrategy funds as an alternative as well as the increasing sophistication of institutional investors who, it was predicted, would shift their capital from funds of funds to single-manager vehicles as they became more comfortable and knowledgeable about alternative investments. Surely last year's slump would deliver the coup de grâce?

It remains early days, but it seems that the death of funds of hedge funds may have been greatly exaggerated. Many funds of funds ran into trouble last year, of course, but anecdotal evidence suggests that investors are often willing to go along with restructuring proposals rather than settle for grabbing what they can from the wreckage. Last year's outflows of capital have slowed to a trickle, and there are even reports of the odd new fund of funds being launched.

Why should this be? A lot of the lustre came off multistrategy funds last year. By some reckonings they underperformed both funds of hedge funds and single-manager funds; certainly there was little evidence of consistent ability to reallocate capital successfully in response to market conditions. At the same time, the events of 2008 did little to reassure smaller institutions in particular about their ability to make their own choices of strategy and manager.

So there still seems to be a place for funds that offer somewhat diversified exposure to the hedge fund universe, although investors will be demanding greater evidence of due diligence on underlying managers and may well require fund of funds managers to get by on a lower level of fees.

Put together, these trends point to consolidation in the sector, as only managers with a substantial asset base will have the resources to research and investigate underlying funds with the thoroughness that will be required. Many members of Switzerland's substantial fund of funds industry, much of which consists of vehicles with less than USD100m in assets under management, will need to seek merger partners to survive, according to Peter Meier, head of the centre for alternative investments and risk management at the Zurich University of Applied Science.

Swiss fund of funds do face problems that are not universal in the industry; some of them have extremely low minimum investment thresholds, which bring them within the ambit of more onerous and constrictive retail investment regulation. Fund of funds managers as a whole are facing up to significant changes to their business models as they seek to regain investors' trust and also to start earning the level of fees required for their firms to thrive. Still, it's better than the alternative.